A ‘reset’ button for Roth IRA conversions

The year 2008 marked the 10-year anniversary of the Roth IRA. In its short lifespan, this type of retirement account has greatly increased in popularity because of its favorable tax attributes.
Many people have chosen to take advantage of Roth IRAs not just by funding them, but by also “converting” a portion (or all) of their traditional retirement accounts into them. (A Roth conversion simply allows for the upfront payment of taxes on retirement accounts for future tax-free distributions.) This strategy can work well for many people, but a common problem can arise if account values drop significantly after the conversion.
For example, let’s say early in 2008 you converted your $100,000 traditional IRA into a Roth IRA. Assuming a combined federal and state tax bracket of 35 percent, this would have resulted in $35,000 in taxes.
As we all know, 2008 was an extraordinarily poor year for investments, so assume that after the conversion the account’s value dropped 70 percent — all the way down to $30,000. In this not-too-uncommon instance, you actually paid more in taxes than the entire value of the Roth IRA. In fact, adding the taxes to the market losses ($70,000 plus $35,000), you actually lost $105,000. That’s $5,000 more than the original value of your IRA. Ouch!
The good news here is that the IRS provides a reset button for Roth conversions called a “recharacterization.”
A recharacterization allows you to undo the conversion, thereby offsetting the taxes you paid. In this instance, a recharacterization would result in a $35,000 tax refund.
Even if you’ve already filed your 2008 taxes, it’s still not too late. Simply complete the recharacterization and file an amended return. But there is a deadline to be aware of: Any recharacterization needs to be completed before Oct. 15 of the year following the year of conversion, but you still have plenty of time. (Of course, discuss these issues with a qualified tax advisor.)
The recharacterization takes care of the tax problem, but what if you still wanted the Roth IRA? Simply wait 30 days from the date you recharacterize and then reconvert to a Roth IRA. Since the smaller account value of $30,000 is now being converted, the income tax bill is reduced to $10,500. That’s a tax savings of $24,500, and you still have accomplished your Roth IRA objectives.
Life doesn’t come with too many reset buttons. This is one of the best I can think of.
Orion Melehan is a certified financial planner at LMC Financial Services in Scotts Valley. Contact him at or***@lm**********.com.